Buy 13% Redwood Trust yield. It’s just not 2008 (NYSE:RWT)

Pictures of people

What is a Redwood Trust?

For you 99.876% of Americans who have never heard of Redwood Trust, Inc. (New York stock market :RWT), this is a REIT that invests in and originates residential mortgage debt. Some key facts about Redwood’s investment firm:

  • It holds about $11 billion in residential mortgages. Through securitizations, he sold about $10 billion in interest, leaving him with a net investment of $1.2 billion.
  • Although Redwood transfers most of the interest rate risk through its securitizations, it retains most of the credit risk.
  • About half of mortgages are single-family loans. They are generally “non-conforming”, which means that Fannie Mae and Freddie Mac cannot insure them. What makes them non-compliant is either that they are too large (“jumbo” loans) or have features that do not meet Fannie/Freddie underwriting guidelines.
  • The other half of mortgages are “loans from owners” – to owners of apartment buildings and single-family homes for rent.

And here are some facts about Redwood’s original activity:

  • Redwood originates the type of loans it invests in. But often she finds that selling the loans outright rather than securitizing them makes more economic sense.
  • When it sells the loans, it transfers all of its interest rate and credit risk.

Redwood’s two massive au pair discounts

Discount #1: By management. Because Redwood retains credit risk on its investments, it initially values ​​the loans on its books below face value. I’ll let management figure that out, from their Conference call Q3 22:

“Our equity portfolio was held at an aggregate discount of $458 million to principal value, or just over $4 per share as of September 30. This translated into a weighted average holding price of approximately $0.69 for every dollar on our balance sheet.”

If the loans have no losses, they are obviously repaid at par and the $458 million is recognized as profit. Default losses incurred reduce that $458 million in potential revenue.

Discount #2: Mr. Market. Redwood’s current market capitalization of $819 million is nearly $300 million less than the company’s current book value, meaning investors are discounting these loans even further.

The addition of the two discounts implies that Redwood will bear approximately $750 million in default costs on its $11 billion in gross lending. Is this a reasonable assumption? I firmly say “No”.

Redwood Credit Protection

Curiously, Redwood does not just make random loans. It has underwriting standards. Here are the highlights of his home loan credit risk:

  • Its jumbo loans have an average loan to present home value (LTV) ratio of 44%. Yes, that’s right, 44%, because their average seasoning is 4 1/2 years and house prices have gone up 45% in the 4 1/2 years. And borrowers are strong – average FICOs of 767. Will any of these defaulted loans?
  • Redwood also invested in so-called “repeatable loans” that were restructured after borrowers ran into trouble during the Great Recession. That’s right, the average age of these loans is 16 years old. Their LTV averages 43% (home prices up 65% since inception) and their average loan size is just $159,000. They are messy borrowers – 10% are currently in default – but they have been getting by for 16 years. Will the year 17 bring so much bad luck?

And here are some details about owner loans:

  • Their average LTV is 67%.
  • The properties’ average cash flow is 150% of their loan payment due to Redwood.
  • A large number of single-family rental homes are cross-guaranteed with other homes.
  • Of management -“Over 90% of our bridging loans support a sponsorship strategy of acquiring and stabilizing single-family or multi-family real estate, rather than traditional rehabilitation and short-term sales strategies.”

These are conservative lending standards. The housing market will have to get terribly bad to seriously dig into the $750 million losses the market expects. Could another 2008 housing market just blow this conservative underwriting out of the water?

Why it’s not ’08

The following three images just give you a lot of confidence about this claim. The first image puts the $750 million in supposed investor losses into perspective. $750 million represents about 7% of the loans held by Redwood. How bad is 7% residential loan losses? Disastrous enough, if Fannie Mae’s experience of the Great Recession is any guide. Here are Fannie Mae’s cumulative defaults on these awful loans from 2004 to 2008:

Cumulative Fannie Mae default rates by year of assembly

Fannie Mae

Cumulative “defaults” averaged around 10% on loans from 2004 to 2008. But some of the money is recouped by the lender when the foreclosed home is sold. Assuming a low recovery rate of 50%, Fannie lost 5%. But the quality of Fannie’s loan was far worse than Redwood’s, from LTVs to FICOs to loan terms.

The second image compares today’s and yesterday’s housing vacancy rates. Vacancies are a good measure of the balance between supply and demand. It’s here:

Historical vacancy rates for single-family and multi-family properties

Census Bureau

2008 was a record vacancy rate, the present an all-time low. So there were 2 million more homes on the market. Now there is a shortage of over a million. House prices need to fall much less now for the market to regain its balance. And Redwood landlord borrowers have a much better chance of paying off their debts due to low rental vacancy rates.

Third and finally, there is the quality of the borrower’s loan:

Mortgage Borrower Quality Index

Urban Institute

A dramatic improvement. This means that today’s housing market has far fewer financially fragile homeowners who could be forced into foreclosure in a recession.

To sum up – Redwood is cheap and very volatile.

Two more graphs to close this out. First, Redwood’s historical price-to-book ratio, updated to the end of last week:

Redwood Book Price History

Redwood Trust, Yahoo Finance

The stock just rebounded from its lowest price on record, a reduced book value for investors’ housing fears. Redwood management take advantage of the fear of the market:

“Our analysis shows an attractive opportunity to invest in our own publicly traded shares…We have already expressed this view by repurchasing nearly 60 million common shares in the past five months. We plan to do many more longer in the short to medium term and have sufficient capital to do so.”

This last chart simply shows Redwood’s stock price history:

Redwood stock price history

Looking for Alpha

What I find interesting is that on four occasions in Redwood’s 25-year history, its share price has more than doubled. This is a panic or frenzy stock. We just had another panic. Is a frenzy on the way? I think Redwood is at least a $10 stock, and $12 is certainly reasonable. In the meantime, you have a good chance of cutting a 13% dividend yield.

Comments are closed.